03 September 2012

Risk.net: Keeping above the capital floor

The move to the fair valuation of assets and liabilities is one of the fundamental changes that Solvency II brings. Assets will be valued on a mark-to-market basis, while technical provisions in respect of insurance liabilities will be based on a discounted best estimate of expected future cashflows. And since markets can be volatile, so too will be Solvency II’s economic balance sheet.

As a result, insurers’ capital levels – at a basic level, the excess of an insurer’s assets over its liabilities – are expected to experience significant volatility from one reporting period to the next as the value of assets and liabilities fluctuates.

Insurers will have to maintain eligible capital – or own funds in Solvency II parlance – to at least 100 per cent of its solvency capital requirement (SCR) to prevent regulatory interference and ensure operating flexibility. Insurers are, therefore, expected to hold a capital buffer above the regulatory requirements.

No company wants to hold excess capital, but in a volatile environment how can insurers achieve capital efficiency without running the risk of breaching their (SCR) – and what will happen if they do?

This new volatility presents significant challenges for insurers. First, there is the problem of a company simply understanding what its capital position is. Measuring risk and calculating capital can be complicated and time consuming, especial in today’s abnormal markets.

Smaller companies that do not manage their assets in-house could have more difficulty in obtaining detailed data on their assets than those that do have in-house investment.

An important step is for insurers to gain experience of how their balance sheets will move under Solvency II so that they can understand the nature of the problem and how they might respond, says Bruce Porteous, head of Solvency II and regulatory development at Edinburgh-based Standard Life.

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